Chapter 7 The Consumer of FinancialServices - Princeton University

[Pages:23]Chapter 7

The Consumer of Financial Services

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Contents

Page Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167

Consumer Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167 Consumer Savings and Investment Behavior . . . . . . . . . . . . . . . . . . . . . . 168 Providers of Consumer Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . 169 Consumer Payment Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171 Growth of Consumer Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173 Recent Innovations in Consumer Financial Services . . . . . . . . . . . . . . . . 174 Automated Teller Machines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176 Automatic Direct Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 Telephone Billpayer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 Point-of-Sale Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 Home Information Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 Pricing Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 Opportunity Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179 Information Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179 Communication Costs .. .. .. .. .. .. .. $. .. ... ... .$...... . . . . . . . . . . 179 Competition and Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

Public Policy and the Financial Service Consumer. . . . . . . . . . . . . . . . . . . . 180 Regulations Relating to Consumer Finance. .'. . . . . . . . . . . . . . . . . . . . . . 180 Consumer Credit Protection Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182 Regulations Z and M . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182 Electronic Funds Transfer Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183

Transition From Paper-Based to Technology-Based Systems . . . . . . . . . . . 184 Security of Consumer Assets in a Technology-Based System . . . . . . . . . 184 Privacy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185 Consumer Rights to Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . 186

Tables

Table No.

Page

9. Household Financial Assets and Liabilities, 1982

(billions of dollars). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169

IO. Credit Card Holding (families holding cards as percent of

all families). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172

11. Credit Carouse (families using cards as percent of all families) . . . . 173

12. Summary of Variances in Regulation and Investor Protection. . . . . . . 181

Figure

Figure No.

Page

14. Lifecycle of Consumer Needs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170

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Chapter 7

The Consumer of Financial Services

Introduction

Consumers' of financial services have characteristics distinct from all other financial service user groups. Approximately 80 million households comprise this group; and as such, it is an important part of the U.S. economy. Household deposits provide the financial service industry with nearly $2 trillion in loanable funds. In addition, consumers have a diversity of needs and compose a highly segmented market, Consumers, in comparison to their use of other instruments, also make the least use of technology-based financial services and products.

It is readily accepted that although some movement has been made toward consumer acceptance of technological devices in banking, the time horizon for acceptance by the total population will be much longer than 10 years. There are currently some highly visible examples of the effect of technological change on this market segment (e.g., the rapid acceptance of automated teller machines (ATMs)), but certain institutional relationships have been affected little by the technology. As some new systems are implemented, however, and certain of the institutional problems with these implementations are resolved, the effects of technology on the consumer of financial services are bound to become more evident.

Historically, the banking sector of the financial service industry has been either enamored of or totally uninterested in pursuing the con-

`The consumer, as defined here, is an individual user of personal financial services.

sumer as a potential customer. It appears, however, that competition is changing some of the indifference of banks toward this market. "It was not regulation or legislation that allowed nonbank institutions to exploit the opportunities available in upscale credit cards (American Express), in discount brokerage (Merrill Lynch), and in automated payroll services (ADP). Rather it was the failure of banks to engage in effective marketing and their lack of innovation and understanding of consumer attitudes that gave the near-bank competitors the upper hand in these product areas.'" As a result, the consumer is beginning to wield more power in product development; recent events are changing consumer financial services from being product-driven to being market-driven. It is not clear, however, if all consumers are benefiting from these changes.

Consumer protection regulation has in the past dealt with the protection and fair treatment of consumers in the financial service system. Implicit in the formulation of public policy has also been the recognition of the potential impact of technology-based systems on the consumer. However, it is important to fully understand the changes taking place, their impact on the role and behavior of the consumer, what new issues will arise because of these changes, and existing issues that have not been adequately addressed. ----------

`Richard Rosenberg, Vice Chairman of W'ells Fargo, as quoted in The Retail Banking Re\'olution: An International Perspectit'e, Patrick Frazer and Dimitri }Tittas (eds. ) (1.ondon: Nlichael I,afferty Publications, 1982), p. 7.

Consumer Financial Services

Consumers seek financial services to facilitate payment, to balance current income against future consumption through savings

instruments, to balance present consumption against future earnings with credit instruments, to secure growth in capital, and to safe-

167

35 -505 ~ - 84 - 12 : QL 3

168 ? Effects of /formation Technology on Financial Services Systems

----.--

--

--.

guard their assets. A rational consumer who wants to maximize his objectives will desire control over the means (i.e., assets and income) to those ends. The degree of his control is measured by the extent to which his assets meet his needs.

In this regard, Professor William White, in his report to the Investment Company Institute, The Outlook for Money Market Mutual Funds, defines the demand of consumers for specific financial products and services as arising not from the particular product or service, but from features of the consumer and his environment. Demand arises first from the necessity for the individual consumer to meet certain basic needs, which can be classified as convenience, return, liquidity, security, credit availability, and, to some extent, personal service. The investment behavior of the consumer is related to the relative importance of each of these needs, which in turn is based on the individual's economic environment and his lifecycle stage. Also of importance is the less tangible factor of individual tastes and preferences. 3

Consumer Savings and

Investment Behavior

The term "investment" throughout this section is not used in its macroeconomic sense, that is, the purchase of capital goods. For this chapter the term means the commitment of money specifically to earn a profit, most often by purchasing securities. "Savings" are defined as asset accounts in which an individual accumulates funds for future consumption. For the most recent statement of total outstanding assets and liabilities for the household sector, see table 9.

The primary savings instruments used by individuals are time and savings deposits, pension funds, and home mortgages. In recent years, more consumers have begun using the money market fund for savings. The figures for 1982 do not reflect, however, the more re-

`William L. White. "The Outlook for Money Market Mutual

Funds, " Report to the Investment Company Institute, Sept.

30, 1982, pp. 28-29.

cent movement of funds out of money market funds into their depository equivalent, money market deposit accounts. These figures will be reflected in 1983 end-of-year accounts.

Life insurance funds are also used for accumulating savings; however, because of their low rate of return, their primary function is insurance against risk. Individuals also invest a considerable amount in securities, both corporate and government.

Home mortgages, although they represent a liability relationship for the consumer, are, in effect, instruments of negative savings in which the consumer initially creates a debt relationship with an institution. However, as the consumer decreases his debt, he earns equity in the property; as the value of the property increases over time, it increases the net worth of the individual.

The relationship of assets to liabilities and the choice of instruments for investment varies with the age and income of the consumer. This is depicted graphically in figure 14. The primary earning years are between the ages of 20 and 70, when generally the consumer earns more than he consumes. With age, savings and investment behavior of the consumer changes. Generally, in youth, the consumer will be more consumption-oriented; as age and income progress, the consumer will be more future-oriented. The consumer's basic needs of convenience, higher return, security, liquidity, credit availability, and personal security often correspond with this lifecycle and directly influence which financial service and products he selects.

Although aggregate information on the savings habits of consumers reflects a propensity to invest, an overall tendency to save rather than borrow, and a pattern of savings highly correlated to age, consumers differ in their objectives for asset management. The financial service industry has recently begun to react to these differences and to provide services to meet very individual needs in addition to providing instruments that have widespread use (e.g., checking and savings accounts, bank credit cards, or mortgages).

Ch. 7--The Consumer of Financial Services q 169

Table 9.-- Household Financial Assets and Liabilities, 1982 (billions of dollars)

Assets:

Deposit and credit market instruments .,

Deposits ., ., . . ... ... . . .

Checkable deposits and currency . . . . . .

Small time and savings deposits . . .

Money market fund shares . . . . . . . . .

Large time deposits ., . . . .

Credit market instruments ., . . . .

U.S. Government securities ., ...

Treasury issues . . . . . . . . .

Savings bonds ... . . . . . .

Other Treasury ... , . . . . . .

Agency

issues

.

State and local obligations . . . . .

Corporate and foreign bonds . . . . . .

Mortgages . . . . . . . ., .,

Open market paper. . . . . . . . . . . .

Corporate equities . . . . . . . . . .

Mutual fund shares ., ... . . . . .

Other corporate equities . . . . . . Life insurance reserves ., . . . . . .

Pension fund reserves ., ., ., ... .,

Security credit . . . . . . . . .

Miscellaneous assets . . . . . . . . . .

$2,781.3

1,316,2 1,316.2

935.3 16.0 85.3

1.982.7 798,6

89.5 1,226,8

307.3 1,322,9

206.6 145.9

377.0

129.0 64.5 186,5 41.6

Total assets . . . . . . . . . . . . . $5,381.0

Liabilities: Credit market instruments . ., .,

Home mortgages . . . . . . . . . . . . . . . . . . . Other mortgages . . . . . . . . . . . . . Installment consumer credit . . . . Other consumer credit ... ., ., Bank loans n.e.c.a. . . . . . . . ... . . . . Other loans . . . ... . . . . Security credit . . . . . . . . . . . Trade credit . . . . . . . . . . . . . . . . . . . . . . . . Deferred and unpaid life insurance premiums

1,674.4

28.8 22.2 15.5

1.101,0

36.4 344.8

85,9 33.3 730

Total liabilities. .. .. ... . . . . $1,740,9

N O T E Households Include not for profit orqanlzat!ons aNot elsewhere class lf~ed

SOURCE Board of Governors Federal Reserve System Flow of funds Accounts: August 1983

291,8 85.2

68.3 223.4

Providers of Consumer Financial Services

For the most part, consumer needs cannot be met without the assistance of an intermediary that provides access to payment systems and markets, expert knowledge and advice, the pooling of a large number of individual risks (as with insurance protection), or a diversified portfolio for a minimum investment (as with investment companies).

In the past, consumer financial institutions specialized in individual products and services. As a result there were some institutions that provided for the payment needs of the consumer, some which provided for his/her savings and credit needs, and still others that pro-

vided for his/her insurance needs, Regulation tended to support this specialization. Recent trends in the marketplace and in regulation are beginning to break down the strict distinctions between institutions. Many consumers are adapting readily to the changes and are changing traditional relationships with some financial institutions.

Prior to these recent events, the most widely recognized financial relationship for the consumer was with a depository institution, especially with a bank. Banks provided the consumer access to the payments mechanism through checking accounts and met some credit and savings needs. Savings institutions pro-

170 . Effects of Information Technology on Financial Services Systems

--

--.

.--

Figure 14.-- Lifecycle of Consumer Needs

I

Earned income (excluding investment income and transfers)

F=/

\

~~

o

10

20

30

40

50

60

70 age in years

~~~ ~

Usually

First

Prime working and earning

Supported by income

supported by

jobs

years

from savings, retire-

parents

family

ment or welfare

benefits

For the purposes of the financial services industry, people do not become consumers (do not buy) financial services usually until at least their teens:

General age

New financial activities

Resulting financial service(s) requirements

Teens-

First jobs (though often still

Transaction accounts, simple savings

20's

with parent support).

accounts or instruments (e.g. U.S.

savings bonds).

Often, college.

Education loans.

Often, car or other major purchase. Auto or other loans

--.

Auto insurance.

-.

20's

First home purchase or more saving Home mortgage.

to prepare for home purchase.

More sophisticated savings instruments,

Marriage and first children.

Various loans (general credit).

Related: perceived need for greater Insurance, savings

security to protect family.

life, health, home.-- ins--urance,

30's

Prime working-and earning years: ?

60's

Higher income,

Tax shelters

Larger saving base being built,

More sophisticated investment vehicles:

as foundation for children

securities, money target funds, real

education and other expenses,

estate, insurance purchases.

and for old age.

real-estate pension plans.

More business travel.

Financial advice often desired.

More income for personal travel.

Traveler's checks, travel and entertain-

ment credit cards.

High of 0/0 time working, especially Cash dispensers, debit cards.

two career couples (2 earner

families): result - need for

greater convenience in trans-

actions, more mail order and

overall--p--urc. hases.

60's

`- Often retirement or less working `- Financial advice, to plan for supporting

time, more leisure, less earned

a standard of living

income.

lesser risk, higher current Income

(securities), investments, pension

trust, estate planning.

SOURCE William L White, "The Outlook for Money Market Mutual Funds, " 1982

Ch. 7--The Consumer of Financial Services q 171

vialed savings and mortgage services. Credit unions provided services similar to those provided by both commercial banks and savings institutions.

Recent research shows that the typical consumer deals with only one or two banks and will accept fairly standardized products.' However, it also shows that there is very little consumer loyalty toward a particular institution; if another institution can meet the needs of the consumer better, the consumer usually moves his business. A consumer "wants to be able to use a credit card to purchase goods and services from merchants, and he wants to be able to use a piece of plastic (preferably the same one, perhaps) to obtain cash from a machine. He does not care who issued the card or who wrote the programs accessing the machines any more than he cares who manufactured the machine. This has been borne out by the rapid movement of funds out of traditional deposit accounts in the 1970's to accounts with a higher rate of return. In the past, most so-called consumer loyalty was illusory in that banks had a monopoly on certain types of transaction accounts and often had a geographic monopoly, as well.

Individuals with higher discretionary incomes, a desire for high growth of assets, and lower risk aversion will generally have a relationship with a securities house. High income, or, in its place, low risk aversion, was generally necessary to offset the risk associated with the instruments offered through these institutions.

It is evident that consumers have also had fairly complex financial relationships with nontraditional financial service providers. Historically, retailers have extended credit to their customers to purchase goods and services. From this has developed a fairly substantial number of consumers with revolving credit lines, and credit cards to access these lines of credit. Sears and J. C. Penney have two of the

`Arthur D. Little, Inc., Issue and Needs in the Nation's Payment System, The Association of Reserve City Bankers, April 1982, p. 35.

5Paul Horvitz, American Banker, New York, Sept. 24, 1982.

largest card bases in the United States and have filled certain consumer financial needs for years. Both are favorably placed in the financial service marketplace because the consumer recognizes their names. As the consumer becomes used to nontraditional providers of financial services, he may willingly accept retailers as providers.

Consumers may obtain cash from a variety of other places besides banks; for example, individuals routinely cash checks at a grocery or convenience store solely for the purpose of cash acquisition. Although these retailers are not financial institutions in the traditional sense, they certainly have provided consumers with financial services in the past. Grocery stores have used check guarantee systems for a number of years, and as mentioned earlier in this report, some are beginning to offer more technologically sophisticated services--for example, onsite ATMs.

The ways in which the financial service industry is changing are described more fully elsewhere in this report. The effect of these changes on the consumer has been to offer him a greater realm of choice in the institutions with which he can do business.

Consumer Payment Methods

Like the business sector, the consumer requires payment mechanisms to acquire goods and services. Recent research has postulated that a consumer seeks as many as 11 specific attributes in a payment system: budgeting, documentation, reversibility, spending control, transaction record, leverage potential, acceptability, transaction time, transfer time, social desirability/prestige, and security.6 Each consumer will choose his method of payment according to his priorities and to his perception of a particular method as having the specified attributes.

By far, the most commonly used medium of exchange for point-of-sale (POS) purchases is

`Elizabeth C. Hirschman, "Situational Perception of Product Prototypes Within the Product Class of Consumer Pa~'ment Systems. " The Journal of Genera) PsJ'choJogTr, \ol. 106, 1982, p. 127.

172 q Effects of Information Technology on Financial Services Systems

cash, particularly for small transactions. The primary attributes of cash are convenience and acceptability. Since cash is universally negotiable and requires no personal identification for use, cash transactions also have the additional attribute of privacy; however, these same qualities make cash a less secure medium of exchange. For the approximately 17 percent of all households that have no relationship with a financial service institution, either cash or (in specific instances) money orders or cashiers' checks, are the only instruments of payment available.

Many consumers use checks to meet these needs. Studies show that the consumer's use of checks has consistently been in the range of 50 percent for bill payment, 31 percent for retail purchases, 9 percent for payments to other individuals, and 8 percent for cash acquisition. 7 The figures for cash acquisition are probably low, since many checks written to retail institutions are actually for acquiring cash. In 1979, consumers' checks accounted for approximately 53 percent of all checks written, or 17 billion transactions.8

Until the 1950's, the personal check was truly the only widely used alternative to cash for payments. In recent years, however, the check has become less negotiable; consumers frequently are required to have additional identification and some proof of creditworthiness in order to use a check for POS purchases. In part, the decreasing negotiability and lack of national acceptance of the check led to the explosion in the availability and use of other payment mechanisms for the consumer--e.g.,

traveler's checks, retail credit cards, travel and entertainment (T&E) cards, the bank credit card (in the 1960's), and, most recently, the debit card.

The traveler's check and the T&E card provided the consumer with payment mechanisms more negotiable than the check, with attributes of convenience and acceptability, yet more secure than cash. T&E cards are

`See Economic Review, "Special Issue: Displacing the Check"

(Atlanta, Ga: Federal Reserve Bank of Atlanta, August 1983), p. 8.

`Ibid., p. 26.

charge cards and, except in certain instances, do not provide long-term credit to the consumer. When they were introduced, the consumer did not have highly developed credit needs. T&E cards met the additional consumer needs of spending control and leverage potential. In addition, the high membership fees and apparent exclusivity of the cards provided a sense of social prestige. Although it was thought that with the introduction and widespread use of bank credit cards, the number of T&E cards in circulation would dwindle and their usefulness would be outdated, their number has actually grown.

Bank credit cards9 are used in most cases

as an alternative to cash or checks for POS

transactions. Their line of credit added flexibil-

ity to consumer payment mechanisms. Bank

cards are perceived by the consumer to be

more acceptable and less time-consuming to

use than checks and less risky than cash. They

also provide the consumer with proof of pay-

ment, which facilitates returns or reimburse-

ment. The majority of credit card users do not

actually use the credit option associated with

the card, paying instead the full amount owed

each month.10 The card is viewed more as an

instrument of cash management. Tables 10

and 11 show overall consumer holding and use

of credit cards.

.----

9The term "bank credit cards" is rapidly becoming somewhat of a misnomer. This term commonly refers to VISA and MasterCard interchange cards, which in the past were issued by banks. However, these cards (although for the most part still issued by banks) now provide access to a variety of' accounts, including central asset accounts offered by securities houses.

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o

n

o

m"

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v

i

e

w

,

Op.

cit.

Table 10.--Credit Card Holding (families holding cards as percent of all families)

Year

Type of credit card

1977 1978

1981

1982

Any . . . . . . . . . . . . . . . 63

64

66

70

Gasoline . . . . . . . . . . . 34

34

30

35

Bank ... , . . . . . . . . . . 38

40

45

51

General

purposea . . . 8

10

14

14

Retail store . . . . . . . . 53

50

57

63

Other b. . . . . . . . . . . . . 6

5

7

NA

aTravel and entertainment cards.

blncludes airline cards, car.rental cards, and others not classified elsewhere

NA--not available,

SOURCE Data collected for the Federal Reserve Board by the Survey Research Center, University of Michigan.

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